P/B ratio as Invesment Strategy

What is P/B ratio?

• It compares the market's valuation of a company to the value of that company as indicated on its financial statements.
• Price to Book = Price per Share/Book Value of Common Equity
• Book value of equity is the difference between the book value of assets (cash, accounts receivable, inventory, equipment, etc.) and the book value of liabilities (loans, accounts payable, mortgages, etc) - if you liquidated a company, this is what the leftover assets would be worth after paying off all the debts.

Low P/B Strategy 

• Low P/B  could signal a stock that is currently undervalued. 
• It is least likely to suffer serious share-price declines in the future
• Research has shown that low P/B stock have less downside risk & tend to outperform the overall market pretty consistently over long periods of time.

Undervalued or Underperformer?

•  A low P/B ratio (<= 1.0) can mean one of two things:
•  The stock is selling at a discount to its fair value - A buying opportunity
• Something is fundamentally wrong with the company - Avoid it like the plague.

Limitation on P/B ratio

• It only work well for companies with a good deal of assets on their books
• Intagible assets are ignored - it may not be very applicable to service firms.
• Acquisition can boost the book value and decrease the P/B ratio as a result
• Share buy back lead to lower book values.

ROE + P/B - Theoretical background

• The financial theory postulated by John Burr Williams in his “The theory of investment value” says the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate. The simplest model for this purpose would be the Gordon constant dividend growth model for a stable firm.
• Eq 1: P₀ = DPS₁ / (r-g)  
• P₀ = Value of equity 
• DPS₁ = Expected dividends per share next year 
• r = Required rate of return on equity 
• g = Expected growth rate in dividends (forever)
• Divide both sides of Eq 1 with Book Value of Equity Per Share, BVPS
•  Eq 2 : P₀ / BVPS = (DPS₁ / BVPS) / (r-g)  
• P/B = DPS₁ / EPS₁ *  EPS₁ / BVP / (r-g)
• P/B = Expected Payout Ratio * ROE / (r-g)
• Based on above Eq, the PB ratio will
• Increase - expected growth rate increase
• Decrease - if firm have higher cost of capital
• Increase - if firm have higher ROE (more efficient)
• ROE - A measure of how well a company is using reinvested earnings to generate additional earnings
•  If a company’s ROE has been on the rise, so should its P/B ratio - one should take notice if there is a large discrepancy between the ROE and P/B
• Expected Growth Rate, g = ROE * Reinvestment Rate = ROE * (1- Expected Payout Ratio)
• g/ ROE = 1 - Expected Payout Ratio
• Eq 3: Expected Payout Ratio = 1 - g/ROE
• Substitute Eq 3 to Rq2
• P/B = Expected Payout Ratio * ROE / (r-g)
• P/B = (1 - g/ROE) * ROE / (r-g) = (ROE/ROE - g/ROE) * ROE/(r-g)
• Eq 4: P/B = (ROE - g) /( r - g)
• Based on Eq 4: 
• Growth doesn't look to be a convincing factor for P/B
• We should compare the ROE vs the Cost of Capital

Investing using the low P/B ratio strategy

•  Additional screening criteria for low P/B stock
• P/B < 1.5
• Debt / Capital < 70%
• ROE > 8%

 
References:-

• Low Price-to-Book Investing Strategy  kcchongnz (private)